Client Service June 1, 2021

Unintended Tax Consequences Arise When the RMD Date Shifts

The concept of extending the age at which one must begin drawing tax-sheltered savings as income in retirement is like candy, one source says: Everybody loves it, but too much of it can be a bad thing.
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When it was passed into law at the very end of 2019, the Setting Every Community Up for Retirement Enhancement (SECURE) Act moved the age for required minimum distributions (RMDs) from 70.5 to 72.

Subsequent legislation introduced near the end of last year and recently passed out of the House Ways and Means Committee would move the RMD age out further, to 75. While it’s a popular proposal, sources say extending the RMD age again so soon could have some unintended consequences, including adding to the confusion that many people already have in grappling with the complex set of rules and regulations governing the RMD process.  

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A Long Way From RMD Clarity

Ed Slott, a CPA and IRA expert with Ed Slott and Co. who also offers adviser training courses in collaboration with the American College of Financial Services, says he appreciates the motivation behind extending the RMD age, which is ostensibly to grant greater flexibility to retirees as they consider how to most efficiently organize their financial lives after their working years end.   

“Extending the RMD age is like candy—everybody loves it,” he jokes. “However, like candy, we have to understand that addressing RMDs is not enough all by itself. In fact, too much of it can be a bad thing.”

Slott says he has seen a tremendous amount of confusion among pre-retirees and older investors about what changes have been made to the RMD framework. The uncertainty started with the passage of the SECURE Act, which declared that if a person reached the age of 70.5 in 2019, the prior 70.5 RMD age continued to apply, but if he reached age 70.5 in 2020 or later, he must take his first RMD by April 1 of the year after he reaches 72.

“This was confusing enough for people to absorb, and then you had the first coronavirus relief bill also addressing RMDs,” Slott reflects, referring to the Coronavirus Aid, Relief and Economic Security (CARES) Act.

Among its many relief provisions, the CARES Act essentially waived all RMDs for 2020, recognizing that the government did not want to force people to withdraw money from investment accounts at a time when the markets were so troubled. The law also created a special temporary framework that would allow people to recontribute any 2020 RMDs that had already been taken during the year prior to the outbreak of the coronavirus pandemic.

“Between the SECURE Act, the CARES Act and now the follow-up legislation, I have heard so many questions from my clients about what it all means, and they are looking for their advisers and accountants to have real answers to their questions,” Slott says. “One of the things that advisers should be doing is connecting with clients’ accountants and any other resources they can. These are high-value conversations going beyond simply talking about managing money, and your clients will appreciate it.”

Errors and Omissions

Slott says his main concern is that people will remain confused and will potentially make costly tax mistakes in the coming years. Additionally, they might simply assume that waiting for the pushed-back RMD date makes sense for their unique money situation, when, in fact, it could be a highly inefficient approach from a tax mitigation perspective.

“People need to remember that every year you push back the RMDs, the more quickly that money will have to come out in the future, which means the annual distributions and the annual taxes are potentially going to be higher,” he says. “Advisers and accountants should look at this very carefully and help people to make the optimal decision. Perhaps a person should consider a Roth conversion, for example, or another conversion strategy, rather than wait for the 72 or 75 RMD age.”

Slott’s personal view is that the government should do away with the RMD age entirely, especially now that the thorny issue of the abuse of so-called “stretched individual retirement accounts” was resolved by the SECURE Act. Prior to the SECURE Act’s adoption, IRA owners could pass their accounts to an heir at death, potentially someone a lot younger than them. With the right approach, this strategy could be used to preserve sizable accounts for future generations, while continuing to grow the money tax-free for years or decades. The SECURE Act, recognizing this loophole, today requires that most beneficiaries of unspent IRAs take full account distributions within 10 years.

“With the stretch issue solved, there’s no reason to have lifetime RMDs anymore, in my opinion—other than to annoy seniors,” he laughs.

High Value Conversations

While he’s less prescriptive in proposing policy solutions, Moneta Partner Gene Diederich has had a similar experience in the past year fielding questions and concerns about RMDs.

“We’ve been busy doing more and more income planning and estate planning, based at least in some part on the demographics of our client base and the fact that the Baby Boomer generation is reaching this stage in life,” Diederich says. “I’m sure we aren’t the only advisers whose clients are expecting more advanced planning than ever before. What makes it all the more engaging and challenging is that we can’t exactly predict the future of where tax laws will go.”

Diederich says the RMD issue impacts clients of all types, noting that the RMD age can have a big effect on “corporate executive types” and those long-time professional employees who have accumulated decades of savings within a well-structured 401(k) plan.

“For our type of clients, who generally do have greater assets than the clients a typical firm might serve, the framework is changing in a positive way,” he says. “Generally, they will have other assets to live on, and so they will not want to take distributions from their private tax-advantaged accounts until they are forced to. For example, a lot of our clients may end up trying to grow these accounts in the markets for as long as possible before using them to make charitable contributions.”

Like Slott, Diederich warns a later RMD date is not necessarily better for everyone, even though it may help many.

“This is also complicated by the fact that we are probably likely to see higher tax rates in the future rather than lower rates, which adds complexity to the timing of when to start withdrawals,” he says. “In the end, this type of planning is challenging, but it adds a great deal of value to what we are doing for our clients. As an adviser, you can get distracted by the markets and forget to have the deeper conversations about goals and objectives.”

Client Service May 27, 2021

Participant Insights: Misperceptions About 401(k) Plans Abound

Two of the most prevalent misunderstandings that keep workers from signing up—that it is too complicated, and that retirement is too far off to care—can be stamped out through automatic features, advisers say.
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Retirement plan sponsors have to conquer a great number of fiduciary and plan design basics when setting up a plan, but they might not think about the many misconceptions that participants have about retirement plans and retirement saving—which could be an impediment.

Two of the biggest misconceptions that keep workers from participating in retirement plans are that they are too complicated and that the worker is too young to care about a milestone decades down the road.

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“Some of the very most harmful misconceptions that participants have, have to do with the feeling that retirement plans are so complicated that they cannot make prudent decisions,” says Molly Beer, an executive vice president in the retirement plan consulting practice at Gallagher in Chicago. “The mere idea of using the plan to get themselves to retirement can often feel overwhelming.”

Related to this is the thinking among young participants that retirement is so far away that they don’t need to start saving now, says Christian Mango, president at Financial Fitness for Life, a financial wellness provider, in Winchester, Massachusetts.

“Even $1 grows, and the later you begin planning and saving for retirement, the more difficult it is to save enough,” he says. “Being invested and letting the money generate compound interest is the name of the game.”

While these and other misconceptions, like what deferral rate to choose, can be largely stamped out through automatic enrollment and automatic escalation, advisers say, it is not enough to use auto-features without also providing communication and advisory support. Participants need education and individual financial planning to fully appreciate and make the best use of their plan, experts note.

Besides getting participants into the retirement savings game, automatic features free them up to work with advisers on their immediate- and short-term financial needs.

“This means advisers can focus on individual financial coaching as opposed to general education, which participants may or may not benefit from,” Beer says.

Myriad Misunderstandings

Another potentially confusing feature of retirement plans that precludes people from participating is the vesting schedule, especially when a participant will not receive the employer match for years, notes Erik Daley, managing principal at Multnomah Group in Portland, Oregon.

On top of this, he adds, there is no single agreed-upon calculation for the retirement income projections that retirement plan recordkeepers will be required to begin providing this fall, under the Setting Every Community Up for Retirement Enhancement (SECURE) Act.

“While the intention and purpose of these projections is good, the assumptions going in will greatly diverge and could confuse some participants and give others a false sense of security,” Daley says. “Some participants may even think these projections are a guarantee of income.”

Another misconception, says David Swallow, managing director of consulting relations and retention at TIAA in Tampa, Florida, is that low-cost investing is superior and that it will always lead to higher portfolio balances—and even a larger pot of money at retirement.

“We think low-cost investments should be part of a diversified lineup, but they don’t always translate into better performance,” Swallow says.

Hand-in-hand with this challenge is participants’ pursuit of the current best-performing funds, Daley says. Those funds might look good now, but that doesn’t mean they’re the best option.

On the subject of annuities, Swallow says the retirement plan industry is now coming around to the idea of prompting those who reach retirement to purchase an annuity outside of the plan. Through its many surveys, TIAA has found that 69% or more of employees place guaranteed income as a top retirement goal, Swallow says.

“But if they wait until retirement, they will pay retail prices, and the psychological hurdle of purchasing an annuity at that point will keep them from taking that step,” he explains. “We think sponsors should give participants the opportunity to have lifetime income options in the plan. That gives people financial confidence. Purchasing an in-plan annuity minimizes peoples’ risk and increases their retirement income. That said, participants need to assess what is right for their particular situation.”

Then there is the issue of fees. “A prevalent misconception among participants is the notion that the retirement plan has no fees,” Daley says. On the flip side of this, some participants think they need to go with expensive investment options with advice embedded in, such as managed accounts. “This could lead to the participant being sold a service or a product they don’t need,” he adds.

Adequate deferral rates are also critical, says Michael Montgomery, managing principal at Montgomery Retirement Plan Advisors in Tampa, Florida.

“It is faulty for employees to think that investment returns are more important than what they are putting into the plan,” Montgomery says. “How much they save is just as critical.”

Because many participants mistakenly think the default deferral rate—potentially only 3% or 4%—is an adequate savings rate to achieve retirement security, sponsors and advisers need to educate them that the actual total rate should be 10% to 15% of their salary each year, including any employer contributions.

“Otherwise, a 3% deferral rate is a disservice to participants,” Montgomery says.

Finally, there are those participants who are averse to risk and volatile markets and who avoid equity investing at all costs, says Matthew Eickman, national retirement practice leader at Qualified Plan Advisors in Omaha, Nebraska.

“Given the three major stock market corrections over the past 20 years—the technology bubble bursting, the financial crisis and COVID-19—many younger participants have been invested far too conservatively,” Eickman warns.

According to Daley, most participants, especially near-retirees, need education to understand what they have and what their options are—such as what Social Security may provide them or what health care supplemental insurance they will need besides Medicare. “People age 50 and older will be more receptive to such education,” he adds.

“First and foremost, there is a financial literacy problem in America,” Mango concludes. “We have to tackle the financial literacy problem from a number of angles. Our schools need to mandate financial literacy as part of their curriculum, and employers need to support overall holistic employee well-being. A critical part of that is financial wellness and education.”

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